Madoff’s Ponzi Scheme Is Not The First (And Will Not Be The Last)

One of the most infamous Wall Street swindlers in history, Bernie Madoff, pled guilty to to 11 criminal counts and was ordered to go straight to jail this week. During his last court hearing, Madoff stated, “I operated a Ponzi scheme.”

What exactly is a Ponzi scheme? How do you spot one? More importantly, how do you avoid becoming a victim?

According to Wikipedia, a ponzi scheme is a fraudulent investment operation that pays returns to investors from their own money or money paid by subsequent investors rather than from any actual profit earned. The scheme is named after Charles Ponzi, who became notorious for using the technique after emigrating from Italy to the United States in 1903.

Investment operations typically do not start out as Ponzi schemes. Instead, legitimate investment operations evolve into criminal schemes due to a number of reasons. For example, a broker may lose a significant amount of investors’ money through risky investments or bad decisions and is not willing to face the consequences from his clients. As a result, the broker entices new investors into the investment operations so that he can pay off prior investors with the hopes that he can make the money back through subsequent investment activity.

As a result, it can be very difficult to spot Ponzi schemes on the front end. There are many red flags, however, that can be easily identified if you know what to look for.

List of Red Flags:

Broker promises of very high returns seemingly without risk.

Broker creates and sends “homemade” monthly statements from the investment operation instead of monthly statements from a recognizable source such as Bank of America, Pershing, etc.

Broker says he is operating a hedge fund or is investing in some other unregulated activity. The investment industry is a highly regulated industry and, as a result, most investment operations are required to be licensed in some capacity. It is very simple to call your state’s securities regulators to find out whether the broker and or the investment operation is licensed or not.

In addition, it is a good idea to follow one simple rule. Do not invest in things you do not understand. If you do not understand it, don’t blame yourself. If you have this mindset, you are more likely to ask more questions which will result in more information that you can use to make an informed decision.